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Introduction to Fundamental Analysis


How Supply & Demand Determine Market Price

Price is derived by the interaction of supply and demand. The resultant market price is dependent upon both of these fundamental market forces. An exchange of goods or services will occur whenever buyers and sellers can agree on a price. When an exchange occurs, the agreed upon price is called the "equilibrium price," or the "market clearing price." This can be graphically illustrated, as in figure 3.

Figure 3

In figure 3, both buyers and sellers are willing to exchange the quantity "Q" at the price "P." At this point, supply and demand are in balance, or "equilibrium." At any price below P, the quantity demanded is greater than the quantity supplied. In this situation consumers would be anxious to acquire product the producer is unwilling to supply resulting in a product shortage. In order to ration the shortage consumers would have to pay a higher price in order to get the product they want, while producers would demand a higher price in order to bring more products on to the market. The end result is a rise in prices to the point P, where supply and demand are once again in balance. Conversely, if prices were to rise above P, the market would be in surplus -- too much supply relative to the demand. Producers would have to lower their prices in order to clear the market of excess supplies. Consumers would be induced by the lower prices to increase their purchases. Prices will fall until supply and demand are again in equilibrium at point P.

A market price is not a fair price to all participants in the marketplace; it does not guarantee total satisfaction on the part of all buyers and all sellers. This will depend on their individual competitive positions within the market. In addition, a market price will play a central role in shaping and reshaping the competitive landscape of an industry: A very low a price will result in excess profits for the buyer, attracting competition. Likewise, a very high a price will attract additional producer competition within the market. Therefore, there will exist different price levels where individual buyers and sellers are satisfied, and the sum total will create a market or equilibrium price.

Figure 4

When either demand or supply changes, the equilibrium price will change. For example, good weather normally increases the supply of grains and oilseeds, with more product being made available over a range of prices. With no increase in the quantity of product demanded, there will be movement along the demand curve to a new equilibrium price in order to clear the excess supplies off the market. Consumers will buy more but only at a lower price. This can be illustrated graphically, as in figure 4.

Similarly, a shift in demand due to changing consumer preferences will also influence the market price. In recent years, for instance, there has been a shift in demand on the part of overseas Canadian wheat buyers toward the Canada Prairie Spring varieties, away from the Hard Red Spring varieties. A decline in the preference for Hard Red Spring wheat shifts the demand curve inward, to the left, as illustrated in figure 5. With no reduction in supply, the effect on price results from a movement along the supply curve to a lower equilibrium price where supply and demand is once again in balance. In order for prices to increase producers will have to reduce the quantity of hard red spring wheat brought to the market place or find new sources of demand to replace the consumers who withdrew from the marketplace due to changing preferences or a shift in demand.

Figure 5

Changes in supply and demand can be short-run or long-run in nature. Weather tends to influence market prices generally in the short-run. Changes in consumer preferences can have either a short-run or long-run effect on prices depending upon the goods or services -- for example whether they are luxuries or necessities. A luxury good may enjoy a short-term shift in demand due to changing styles or snob appeal, while necessities tend to have stable or long-run demand curves. Another major factor influencing market prices is technology. A major effect of technology in agriculture is to shift out the supply curve rapidly by reducing the costs of production on a per unit basis. At the same time if total demand does not increase sufficiently to absorb the excess goods produced at lower costs, the long-run impact of technology on the market place will be to lower prices. The rapidly outward-shifting supply curve, coupled with a slower moving demand curve, has generally contributed to lower prices for agricultural output when compared to prices for industrial products.

Next chapter: The Important Stocks-to-Use Ratio

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